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The Smart Way to Invest in Marijuana Stocks

Investing in high-growth pot stocks is risky. But there are clever ways to mitigate that risk and take part in the green rush.

As of Wednesday, Oct. 17, 2018, recreational marijuana sales are under way to adults in licensed dispensaries throughout Canada. This makes our neighbor to the north the first industrialized country in the world to have given the green light to recreational pot and only the second nation overall, behind Uruguay, to do so.

What does legalization mean for the legal cannabis industry? Although estimates tend to vary wildly, Wall Street appears to be looking for $5 billion or more in added annual sales from domestic demand and via exports once things are fully up to speed. This exceptionally rapid sales growth is expected to translate into healthy profits for the industry.

Image source: Getty Images.

Investing in pot stocks made simple

But as investors, we also know that not every marijuana stock will be successful. Some clear winners will emerge, as well as some monumental flops. We also know that, given the euphoria surrounding legalization in Canada after nine decades of adult-use prohibition, volatility will be high (pun intended). This makes investing in the cannabis landscape particularly risky.

Thus, investors must make a choice: Take part in a burgeoning, high-growth industry or stick to the sidelines to avoid the volatility and possibility of loss?

The good news, however, is that there is a smart way to invest in marijuana stocks. As long as you approach your investments with the following four factors in mind, you should be primed to succeed over the long run.

Image source: Getty Images.

1. Think long term

The single most important suggestion I can pass along about investing in the cannabis industry is that you'll need to be patient. Even though marijuana stocks have delivered incredible returns since the beginning of 2016, all next-big-thing investments need time to mature, and the cannabis industry will be no different.

For example, it's going to take years before the pot industry has production fully ramped up to meet domestic and overseas needs. A rough estimate by yours truly suggests that Canadian growers could be on track to produce 3 million kilograms (or more) annually by the end of 2020. Right now, however, most growers are at anywhere from 0% to 30% of peak production potential.

Take Aurora Cannabis(NYSE:ACB), which is slated to yield at least 570,000 kilograms of weed per year when at peak capacity. But by the end of calendar 2018, it'll only be on track for about 100,000 kilograms a year. Aurora Cannabis has numerous large and costly projects ongoing, such as its Aurora Sun project in Medicine Hat, Alberta, that'll take time to complete and ramp up. Even though Aurora Cannabis could hold a competitive advantage as Canada's largest grower by yield, it's going to take quite a bit of time to reach its peak production numbers.

I can't emphasize enough the importance of thinking long term when buying marijuana stocks.

Image source: Getty Images.

2. Diversify your holdings

Second, it would be a really smart idea to diversify your holdings beyond just one or two pot stocks. That's because it's way too early to tell which cannabis stocks will emerge as winners and which ones won't. All it takes is a few long-term winners, and your portfolio could be seeing plenty of green.

How should you diversify? One option is simply to invest in quite a few marijuana stocks. This option is best suited for investors who are willing to put in the time for research and who plan to keep abreast of the latest news within the industry. Again, this doesn't mean focusing your attention solely on the short term, but it does mean you'll have to keep an eye out for business-altering news and events for the pot stocks you own.

The other option is to go the exchange-traded fund (ETF) route. Buying an ETF like Horizons Marijuana Life Sciences Index ETF (NASDAQOTH:HMLSF) would give an investor access to a basket of cannabis stocks with a single security. The Horizons Marijuana Life Sciences ETF is currently holding 49 different marijuana stocks in the fund and charges a reasonable 0.75% net expense ratio. Plus, the Horizons Marijuana Life Sciences ETF holds companies that are both directly and indirectly in contact with the cannabis plant, making for a truly diversified asset.

Image source: Getty Images.

3. Wade into the pond rather than jumping right in

Regardless of the industry, it's always a good idea to slowly wade into the pond rather than jump right in when establishing new positions.

As noted, there's simply no telling what marijuana stocks will turn out to be long-term winners and which ones won't. History also shows that next-big-thing investments tend to have their bubble burst sooner rather than later. Whether it was the internet, human genome decoding, 3D printing, or blockchain technology, the bubble eventually burst. The same might be true for marijuana stocks.

The best way to protect your portfolio in the event that the bubble does burst is to buy into these stocks multiple times. I like to think of myself as a nibbler. Between 2012 and 2014, I bought into my largest current holding (not a marijuana stock) on 26 separate occasions. While this isn't to say you should follow suit, it'd probably be a good idea to purchase cannabis stocks in regular intervals rather than diving right in and hoping for the best.

Image source: Getty Images.

4. Don't forget about ancillary players

Last, don't forget about the indirect players in the marijuana business. Or, put another way, keep in mind that there's life beyond pot growers.

Buying into indirect players could be a smart way to reduce volatility and buoy your portfolio, since many of these ancillary stocks deal with noncannabis companies as well. For example, Scotts Miracle-Gro(NYSE:SMG) is angling to benefit from medical cannabis growth in the U.S., and perhaps internationally, through its Hawthorne Gardening subsidiary. Hawthorne aims to provide lighting, soil, nutrient, and hydroponic solutions that will help improve crop yields for growers. This fast-growth business could be a nice needle mover for Scotts Miracle-Gro.

But the thing is, Hawthorne was responsible for only 11% of Scotts' 2017 full-year sales. The remainder was generated from its core lawn and garden business. Even if the bottom were to fall out of the marijuana industry, Scotts is able to lean on its core operations to generate healthy profits.

There are plenty of ancillary stocks to consider that can provide this protection for investors.

Author

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and investment planning. You'll often find him writing about Obamacare, marijuana, drug and device development, Social Security, taxes, retirement issues and general macroeconomic topics of interest. Follow @TMFUltraLong